Wednesday, September 1, 2010

Implications of the Recent Shift in Interest Rate Expectations

Jonathan Ogden sends along a couple charts he created to show the recent shift in rate expectations by the market

The Libor chart above is showing the expectations curve of 3-mo libor rates based on eurodollar futures out for 7 years. This shows what the market expects 3-mo libor to be at each quarterly expiration of the contract. Red line is market expectations on May 25th, during the heart of the euro crisis; Blue line is yesterdays; Dashed line is the absolute change.

The Fed Funds chart shows what the market expects the effective fed funds rate to average for the month of each contract, going out about 18 months, based on the 30-day fed funds contract. You can see how the belly of the recent curve(blue line) is getting pulled towards the lower bound and the front of the curve is flattening out, indicating the market is pricing in no appreciable move higher in short rates until mid-2011 and a silent extension of ZIRP.

Jonathan writes:
The trend is in the direction of lower rate expectations for a longer time as traders either

1) believe the Fed can't or won't raise and/or

2) are playing financial chicken on the assumption the Fed wouldn't dare upset the markets with the idea of tighter policy... either way it probably won't end well.
That this probably won't end well is very accurate. One possible scenario is that a flood of new Treasury debt coming to market puts upward pressure on rates causing the Fed to enter the market to buy Treasury securities. This then kicks up price inflation causing a flight away from the current desire to hold large cash balances and ultimately causing a huge spike in rates. Note: This is not a forecast for what will happen next week, but an indication of how events could unfold. Timing is extremely difficult and this commentary is solely to point out that it is extremely dangerous to trade based on the belief that interest rates will stay down for an extended period of time. That is unlikely to be the case. When rates move higher it is likely to be across the yield curve, and given the continued move in the markets toward a belief that rates will stay lower for a very extended period of time, the spike upward is likely to be very fast and furious when it does occur.

1 comment:

  1. I have a question and a comment.

    You write "One possible scenario is that a flood of new Treasury debt coming to market puts upward pressure on rates causing the Fed to enter the market to buy Treasury securities." My question would be with what would they purchase, would they do it directly or covertly through others?

    You relate "When rates move higher it is likely to be across the yield curve" My comment is as follows:

    The purchase of the yen based carry trades on September 1, 2010, rallied stocks, ACWI; and turned the tide on bonds, BND, sending them lower, establishing August 31, 2010 as a high in bonds at 82.66 – establishing August 31, 2010 as peak credit.

    The interest rate on the 30 Year US Government bond, $TYX, rose strongly today, September 1, 2010.

    And the interest rate on the US 10 Year Note, $TNX, also rose strongly today September 1, 2010.

    September 1, 2010 marks the transition from “the age of neoliberal Milton Friedman based credit liquidity” to “the age of the end of credit”; this also means ”the end of entitlements” and “the beginning of world-wide austerity”. Part of the end of entitlement will be that of “living payment free” in a bank’s shadow inventory of real estate property, as banks, being desperate for income will transition from being holders of real estate to lessors of property.

    Yes with the coming stock market driven write down of bank equity, and bond market driven write down of US Treasuries kept at the Federal Reserve in Excess Liquidity, the banks will no longer amend pretend and extend lending as describe by IrvineRenter and others. The bank’s FASB 157 entitlement to value real estate at mark-to-fantasy, rather than mark-to-market will have no meaning in a debt depreciated future.

    The 30-10 yield curve,$TYX:$TNX, began to flatten on August 11, 2010, reversing a trend that goes back to early 2000. This signals risk aversion to sovereign debt. The flattening of the yield curve came as a result of the Federal Reserve Chairmans announcement of August 10, 2010 of the purchase of mortgage-backed securities. Then on August 27, 2010, the Federal Reserve Chairman stated the possibility of an even larger purchase of debt. This caused the bond rally in US Treasuries, TLT, that began April 6, 2010, to fail today September 1, 2010 sending bond prices lower and interest rates higher. The safe haven rally in debt that began with the onset of the European Sovereign Debt Crisis is over. Investors see Mr Bernanke’s plans as monetization of debt; and have gone short US Treasuries, especially the longer out ones such as TLT and especially the zeroes, ZROZ.

    I believe that soon, out of a liquidity evaporation and a liquidity crisis, stemming from a fast fall in bond and/or stock values, that here in the US a Financial Regulator will be announced who will oversee lending and credit, as well as money market and brokerage accounts. He will be what I call a credit boss or credit seignior who funds economic operations with an emphasis on seeing that the strategic needs of the country are met and that monies for food stamps keeps flowing. I believe the government will become the first, last and only provider of liquidity and money.

    I believe that here in the US, the Financial Regulator will exercise Discretionary Governance, and announce a Home Leasing Program administered by the banks, KBE, on their delinquent and REO properties as well as those of Freddie Mac, Fannie Mae and the US Federal Reserve.

    Mortgage lending and securitization of loans will cease, and leasing of homes will be a public private partnership cooperative endeavor. Companies that have created and serviced mortgage-backed securities, such as Anworth Mortgage Asset Corporation, ANH, and Annaly Capital Management, NLY, will quickly disappear from the economic landscape, as mortgage bond funds such as Goldman Sachs Mortgage Bonds, GSUAX, tumble in value.